Friday, 27 January 2012

Banking Industry: A way forward

Banking Industry

The
bankruptcy of Lehman Brothers, investment bank, was the business world’s equivalent
of comic book characters fall off the cliff moment when it suddenly realizes
that it does not have solid ground underneath. For the financial world it
discovered the same on that fateful day, warning signs of what is to come were
many like, when it was reported (2007) that financial institution account for 40% of
corporate profits in US or US national real estate price increase of
100% in less than 5 years!.

Although,
world economy has slowly recovered from that body blow and might be on its way
back to complete recovery (a big If, it can avoid full blown Euro crisis, once
again with European Banks along with its Govt. playing the roles of gladiators).
It is definitely past some time to identify the causes for crisis, so that
decisions could be taken to re-structure the financial industry otherwise it
won’t be long before we have another crisis.

Historically,
banking has been recognized as a unique industry with its own structure of
ownership, rules for governance and regulations. This has been due to its high
risk and high rewards but over a period of time the distribution has changed,
thus currently it has privatized returns (profits) and socialised risks
(losses). Thus Banking industry as a whole has its incentives horribly skewed
towards higher risks this needs to be rectified to ensure that millions do not
have to suffer due to the greed’s of few.

Banking at the start of industrilization

In
the mid 19th century (Europe & US) banking represented the staid
part of the business with a typical firms being unlimited liability
partnerships or mutually owned co-operatives (UK building societies). Due to
unlimited liability owners and managers were one and the same, having their own
personal wealth being at risk. Thus “market” ensured that risk management was
exercised with due-diligence and discipline.

Another
crucial factor in bringing the market discipline was that most of the banks had
equity capital comprising 50% of liabilities while liquid securities and cash
comprise almost 30% of bank’s assets. Thus, bank creditors/depositors were
comfortable in knowledge that if any losses are to be taken it has to be born
first by the owners themselves.

In
terms of taxation there was not any differentiation between equity and debt
thus dividend and debt payments (principal and interest) were made net of taxes
i.e. without any bias towards the structure of financing the business. And
of-course, banks at the time did not have such curious things as “cross-border”
banking where their liabilities and assets are in different parts of the world.

In
mid 19th century UK (it represents a global empire spread across globe)
total financial sector assets represented less than 50% of annual GDP and the
largest bank had less than 5% of GDP in its assets.

How it we get here?

The
change in banking control structure started in 19th century itself
as Western world started industrializing it had tremendous requirement to fund
its new infrastructure and industries (Railways, Ship-building, and Textiles
etc.) and it was felt that unlimited liability was holding back the from
wealthy populace to invest in banks.

Thus,
to address these issues legal changes were made over a period of time in both
UK and US which allowed for banks with limited liability but with a provision
for reserve capital (i.e. the capital that could be called in at the time of
bankruptcy). Thus, even with limited liabilities bank’s total capital (paid up
and uncalled) still represented 50% of its liabilities.

By
start of 20th century a major consolidation took place in financial
industry which meant that as banks were becoming bigger/larger they could not
be managed on earlier partnership model where by owners/managers were one and
the same. Hence, with consolidation came in the practice of professional
managers separate from owners.

At
the start of 20th century laws were changed in terms of treatment of
banks capital and thus debt and interest payment were given tax free status
which was slowly adopted world over. The rationale behind the move being that
for financial industry debt is more akin to a raw material or part of business;
slowly this rationale was applied to non-financial industry.

During
the depression and previous banking crisis (lots of them in USA during its robber baron era) in early
twentieth century, it came to be observed that extended capital was not of much
use as it would always worsen the situation by spreading more panic about bank
as a going concern.

As
a part of policy response to Banking crisis of 1930’s and global depression
many steps were undertaken the foremost being the introduction of Federal
deposit Insurance which was to assure banks creditors so as to not turn a
crisis of liquidity into one of insolvency. To limit the scope of contagion in one part of business causing to other and many bank related governance issues, Glass-Steagall Act 1933 was introduced in USA that
ensured a clear separation between different financial institutions.

Due
to these changes most of the investment banking was to
continued to be a separate entity with partnership structure until late into eighties and would turn
into public listed companies as the regulation climate turned business friendly.

The
last bastion to fall in this climate of de-regulation was the repeal of
Glass-Steagall Act in 1999 combined with very regulation lite for new
derivative industry which was argued for in by such worthies as Greenspan and
Summers. The former allowed the now too familiar behemoths in the form of Citi,
BoA (Bank of America) and JP Morgan to be structured about who it is said that
they are not ‘To Big to Fail’ but rather ‘To Big To Save’.

Where are we?

Now
past three years from last crisis and probably staring into a new one in Europe
which could be dramatically more painful as what was once a private debt on
banking/financial institution has now been converted into a public debt crisis.

Today,
when we survey the banking landscape it is dominated by “all in one” banking
conglomerates, in UK banks have assets more
than 600% of its GDP thus representing undue systemic risk in case of financial
contagion. In 2007, 40% of US corporate sector profits were from financial
sector which earns its income for risk management and transfer, must surely
signifies the mis-alignment of the sector. In US on an average, CEO of a large
bank earn a compensation of $26 million which is 500 times US median household
income while no downside in case of losses indicating malaise called ‘profits are private while losses are public’
helped by ever increasing leverage ratio which was north of 30 before crisis
and still is around 25.

The
banking crisis has had a huge cost not just economical which is substantial but
in terms of cost to society due to huge increase in unemployment, burden of
unsustainable debt, in some cases people with no access to savings for their retirement
years. In a study it was estimated that
total loss due to banking crisis from 2007-2010 is approx. $5000 billion or
$1250 billion per year (equivalent to Japanese GDP).

These
systemic changes have not happened in ideological vacuum but has helped cult like
devotion to Efficient Market Hypothesis (EMH), whereby it has been hypothesized
that market are the best regulator thus all public listed companies merely
require self-regulation (read Alan Greenspan’s testimony to US Congress one of
his gems is “I made a mistake in
presuming that the self-interests of organizations, specifically banks and
others, were such as that they were best capable of protecting their own
shareholders and their equity in the firms.”)! Secondly, laissez-faire
proponents started justifying it as part of next level of evolution, like
earlier one from agriculture to industry, where people argued that finance
could exist for finance sake and not exist as an catalyst to real economy need
to be discarded where we have UK’s PM Gordon Brown wishing to have everyone in
London working financial industry.

We
as a society need to go back to basics, that money is predominantly means of exchange (of course
beside store of value, a function we tend to forget in an era of fiat currency)
and needs to be viewed solely in that context and not as a stand-alone sector
on its own, once financial sector activity is cut-off from real economy than
its activity starts to resemble gambling casinos rather than one of traditional
banks.

Where we want to be?

It
is high time that decision makers need to align the interest of broad society with
that of banking industry, it cannot be allowed to continue in its existing
form of particularly in its perverse risk-reward behaviour.

The
recommended changes are:

Increase equity in financial institution: It has been suggested that optimal equity ratio is about
20% of risk weighted assets. This will align the risk of equity holders with
that of credit holder and will also provide a much needed buffer in times of
crisis but additionally lower the leverage for management to undertake risks.

Introduction of Contingent capital: Banks need to have contingent convertible securities which
will be debt instruments in normal times but will convert automatically to
equity on predefined thresholds (this to be done pre-crisis thus avoiding Time-inconsistency issues). To avoid gaming possibility these securities
should be tradable in market as current crisis experience suggests that market
based equity prices were a better indicator of financial health of institutions
rather than regulatory/accounting reports.

Re-introduce Glass-Steagall Act or Separation of
retail/commercial banking from Investment banking: This is to ensure ring fencing of “every-day” banking
which needs to be protected by state for operational reason as well as for the
well being of its citizens (no bank runs etc). This need to be further strengthened
by imposing lower leverage ratio (lower risks) for retail banks to ensure that
state is not require to be bail out.

Introduce Partnership for Investment banking: Investment banking with its huge risk-reward profile has a
principal-agent problem where agent (management) has incentives to take huge
risks as they do not have to suffer from downsides as oppose to share-holders.
Thus, this needs to avoid such problem by having partnership structure as was
the case before nineties where a deal has to be signed on by shareholders who
were to bear the risk. Also, since this industry is not crucial from every-day
banking aspects hence it cannot qualify for state subsidies but needs to be
treated on par with hedge-funds or private equity.

Measure performance of Return on Asset (RoA) rather on
Return on Equity (RoE): Currently most of financial institutions
are measured on RoE which is flawed measure as it does not account for the
increase in risk profile in search for higher returns. If the bank CEO’s
compensation was to be linked to RoA then their pay would have gone from average
of $ 2.8 million in early nineties to $ 3.4 million in 2007 unlike on RoE which
will take it to $26 million! If any further proof is needed, in US 2007 top 5
CEO with highest stake in their institutions were Dick Fuld (Lehman Brothers), James Cayne (Bear Stearns), Stan O’Neal
(Merrill Lynch), John Mack (Morgan Stanley) and Angelo Mozilo (Countrywide).

Shadow Banking including cross border banking: One of the fallout of
introducing measure such as above is that it might push such activities to
institutions that are not under regulator’s radar, for e.g. most of the banking
regulation is done nationally but banks are allowed to operate globally thus
there is serious lacuna where a bank in foreign country might undertake more
riskier bet thus causing pain to its tax payer for e.g. in Iceland , Ireland
and Spain where most of the private banking bad debt has been laid at the Govt.’s
door.

But
surely, the most profound learning from this crisis is not of one particular
measure but of relaxing the regulatory roles played in finance. Thus, although
the changes in banking industry were being made over last century it is only
with the coming of laissez-faire ideology that this industry ran amuck at
taxpayer’s cost. It is high time where a proactive regulation is brought on
with clear separation between those who are regulator to the ones who are
regulated and ending the practice of revolving-door particularly in USA between
the two. In my opinion finance should be treated on par with pharmaceutical or
health industry as any misstep’s cost has to be borne by society at large.